Implementation of Basel II in Developing Countries: …...Ł Basel II comprises 3 equally important...
Transcript of Implementation of Basel II in Developing Countries: …...Ł Basel II comprises 3 equally important...
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INTERNATIONAL CONFERENCE ON�FINANCIAL SYSTEM STABILITY AND
IMPLICATIONS OF BASEL II�CENTRAL BANK OF THE REPUBLIC OF TURKEY
IMPLEMENTATION OF BASEL II IN DEVELOPING COUNTRIES:
THE CASE OF CHILE
ENRIQUE MARSHALL
SUPERINTENDENT OF BANKS AND FINANCIAL INSTITUTIONS, CHILE
ISTANBUL MAY 16-18, 2005
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AGENDA
1. Key issues for implementing Basel II in developing countries.
2. Preparing the transition in Chile.3. Chile�s road map for Basel II.
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OVERVIEW
! Basel II promises key advances in risk management and banking supervision around the world.
! It is a substantial improvement on the existing accord, but is much more than a new formula for calculating regulatory capital.
! It provides a comprehensive framework for dealing with risk management and banking supervision, and seeks to attain best standards and practices.
! Implementation will have positive effects for financial stability around the world, some of which are already evident.
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GLOBAL ACCEPTANCE
� In the coming years, Basel II will become a global standard.
� It will be adopted by a great majority of countries: 88 out of 107 non G-10 countries have expressed their intention of implementing Basel II.
� This high level of acceptance is seen in all regions of the world.
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NON G-10 COUNTRIES INTENDING TO ADOPT BASEL II
Region
Number of survey
respondents
Respondents intending to
adopt Basel II %
Asia 18 15
16
11
5
7
34
88
Africa 22
83.3
72.7
73.3
71.4
87.5
91.9
Latin America 15
Caribbean 7
82.2
Middle East 8
Non-BCBS Europe 37
Total 107
Source: Survey conducted by the FSI
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BANKING ASSETS IN NON G-10 JURISDICTIONS EXPECTED TO BE SUBJECT TO BASEL II IN 2007-09 *
(PERCENTAGE OF WEIGHTED AVERAGE ASSETS)
77%75%
45%
30%
35%
40%
45%
50%
55%
60%
65%
70%
75%
80%
end-2006 2007-09 2010-15
* ASSETS OF JUST OVER 5,000 BANKS IN 73 JURISDICTIONS.
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SUPERVISORY ASSESSMENT
� The new framework requires fulfillment of certain prerequisites as regards the existing quality of regulation, supervision, and risk management.
! Prior to implementation, it will be necessary to establish an accurate diagnosis of the state of regulation, supervision, and bank management.
! In any case, a number of aspects must be examined:! the legal and regulatory framework;! the supervisory system (risk-based vs. rules-based supervision);! financial infrastructure (accounting and auditing rules);! corporate governance in the banking industry;! financial disclosure and market discipline.
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BCP COMPLIANCE
� Most prerequisites are contained in the Core Principles for Effective Banking Supervision of the Basel Committee (BCP).
! A formal assessment of BCP compliance under an FSAP is a good option since this uses a proven and standard methodology.
� In general, developing countries show only partial compliance with these principles.
� This is a key issue for the implementation of the new capital framework.
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GENERAL BCP COMPLIANCE BY COUNTRY GROUPING
93%
59%
70%
20%30%40%50%60%70%80%90%
100%
advanced developing transition
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COMPLIANCE WITH SUB-GROUP OF BASEL PRINCIPLES RELEVANT FOR CAPITAL ADEQUACY
92%
44%54%
20%30%40%50%60%70%80%90%
100%
advanced developing transition
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RECURRENT PROBLEMS IN DEVELOPING COUNTRIES
� Credit risk under-estimation.� Over-valuation of credit risk mitigants (guarantees & collateral).� Under-provisioning.� Absence of capital charges for market risks.� Under-estimation of capital requirements.� Accounting rules not aligned with international standards.� Lack of consolidated supervision.� Mitigating factor: bank capital requirements usually above the
minimum 8% ratio.
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IMPLICATIONS OF THIS DIAGNOSIS FOR DEVELOPING COUNTRIES
� What are the implications of this diagnosis?� It can be argued that Basel II implementation should be postponed
until satisfactory compliance with BCPs is achieved. � But it can also be argued that Basel II is an extension and deepening
of BCPs, and that the transition should start immediately as part of a wider process of improvement of regulation, supervision, and risk management.
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THE CHALLENGE FOR DEVELOPING COUNTRIES
� Developing countries must take this as an opportunity to raise standards and achieve an important qualitative leap.
� In this sense, the transition to Basel II must be defined as part of a comprehensive program aimed at strengthening risk management and banking supervision.
� This requires identifying the gaps to be filled and setting priorities correctly.
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CONCERN ABOUT MACROECONOMIC EFFECTS
! In developing countries, banks are the main financial intermediaries and bank lending is the major source of finance.
! This explains why Basel II has become such a sensitive issue andits implementation has raised so many legitimate concerns, mainly as regards its potential macroeconomic effects.
! The potential negative effects that are most often cited include:� the level and volatility of capital flows;� the length and depth of economic cycles (pro-cyclical effect);� the behavior of international banking groups, especially on
account of lack of recognition of portfolio diversification.� These concerns have not been fully dissipated and may be settled
in the transition to Basel II.
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ADEQUATE BALANCE BETWEEN PILLARS
� Basel II comprises 3 equally important and mutually reinforcing pillars.
� In most developing countries, the main challenges will lie in the implementation of Pillars II and III.
� It will, therefore, be important to establish the right balance between the implementation of the different pillars.
� It would not, for example, be prudent to move rapidly to the more advanced approaches while weaknesses remain either in the supervisory review process or in financial transparency.
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THE KEY ROLE OF PROVISIONING
� The proper management of provisions is essential for advancing in the implementation of the new framework.
� This is particularly so in developing countries, considering their inherent economic fluctuations.
� Provisions are related to expected risks or losses, which can beassessed using the same concepts proposed by the new framework.
� In this context, provisioning must, in practice, be considered as a fourth pillar in these countries.
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FLEXIBILITY IN IMPLEMENTATION
� In any case, flexibility is key for successful implementation.� This flexibility is provided for in the new framework and has the support
of international organizations, like the IMF and the World Bank.� Developing countries have achieved different levels of progress on risk
management and banking supervision. � Each country should come up with the transition road and speed that
best suit it.
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NO UNIFORM PATTERN FOR THE TRANSITION
� The transition will not, therefore, follow a uniform pattern or time schedule across countries.
� It will be a complex process and might take a relatively long time. � As a result, it will require a great deal of realism and pragmatism.
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STEPWISE IMPLEMENTATION
! Stepwise or gradual implementation seems best suited to the needs of most developing countries.
! A natural process might include 2 or 3 steps, starting with the fulfillment of prerequisites, then moving on to the standardized approach and finally, once the necessary capacities are in place, implementing the advanced approaches.
! This may be complemented by the parallel operation of the existing and new frameworks during the transition period.
! This does not rule out the possibility that some non G-10 countries may proceed to immediate full implementation of advanced internal approaches and models.
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COMPLEXITIES
! Most of the complexities of Basel II are associated with the implementation of the advanced approaches.
! Moving from the present capital regime to the standardized approach ought to be reasonably simple and should not impose an excessiveburden either on supervisors or banks.
! For this reason, some developing countries may decide, based on the structure and risk profile of their banking industry, to keep the standardized approach for a long time. Under Basel II, this is aperfectly valid option.
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OTHER CRITICAL ISSUES FOR THE TRANSITION (1)
! Assessing the competitive or level-playing-field implications of different policy options.
! Making a decision as regards the options for small banks. � Cross-border communication and cooperation (home/host issue). � Communication and cooperation with other local financial-sector
supervisors (insurance and pension funds).
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OTHER CRITICAL ISSUES FOR THE TRANSITION (2)
! Simultaneous advance on other fronts: convergence of accounting rules and ongoing improvements in corporate governance.
! Communication and dialogue with bankers. ! Preparation of an implementation plan (road map), providing
guidelines for the industry. ! Getting banks and bankers involved, particularly boards of directors
and top managers.
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OTHER CRITICAL ISSUES FOR THE TRANSITION (3)
! Strengthening of the private ratings industry (particularly important for the standardized approach to credit risk).
! Development of supervisory capacities for the implementation ofadvanced approaches.
! Training and retaining front-line supervisory staff. ! Preparing legal and regulatory changes.
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PREPARING THE TRANSITION TO BASEL IIIN CHILE
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PERMANENT IMPROVEMENT AS PREPARATION FOR BASEL II
� In Chile, preparation for Basel II has to a large extent coincided with a permanent process of integral improvement of regulation, supervision, and risk management.
� This process goes back to the 1980s when, after a major financial crisis that resulted in the system�s bankruptcy, the foundations of prudential regulation and supervision were laid.
� Improvements in prudential supervision have been in line with international standards and Basel Committee recommendations.
� Preparations included some far-reaching reforms as well as specific actions taken recently.
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MAIN REFORMS AND ACTIONS INPREPARATION FOR BASEL II
� External assessment of BCP compliance.� Implementation of a new risk-based supervisory model. � Reform of the loan classification and provisioning system.� Convergence of domestic accounting rules with international
standards.
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ASSESSMENT OF BASEL CORE PRINCIPLES
� An external evaluation of these principles was carried out in 1999 and revealed a 76% level of compliance.
� During the first semester of 2004, a new evaluation, carried out by the IMF/World Bank under an FSAP program, found compliance of 83%.
� As a result, critical points and weaknesses have been clearly identified and some are on the way to being resolved.
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COMPLIANCE WITH BASEL COREPRINCIPLES IN CHILE
76%
83%
60%
65%
70%
75%
80%
85%
90%
1999 2004
1999: External assessment conducted by independent experts.2004: Formal assessment under an FSAP.
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IMPLEMENTATION OF A NEW SUPERVISORY MODELIN LINE WITH PILLAR II
� The new model focuses on banks´ risk management.� Special attention is given to relevant risks: credit, market, and
operational risks.� This is a major improvement on the traditional rules-based model. � Banks are evaluated periodically and receive an internal rating on a 3-
category scale (A, B, and C).� When weaknesses are detected, corrective measures are
recommended and the involvement of the board is required.� The implementation of corrective measures is monitored by the
supervisor.
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REFORM OF THE LOAN CLASSIFICATION SYSTEM IN LINE WITH PILLAR I (1)
� A new loan classification system was introduced in January 2004.� This system is an effective tool for managing expected losses and
provisions. � It requires close involvement of boards of directors and top
management.� It permits the use of internal models by banks.� A standardized scale of 10 categories is recommended for the
classification of corporate loans so as to facilitate the supervisory review process.
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REFORM OF THE LOAN CLASSIFICATION SYSTEM IN LINE WITH PILLAR I (2)
� In order to estimate loan loss reserves, banks are expected to apply models based on probabilities of default (PD) and other advanced credit-risk concepts.
� A period of consolidation of this reform is required before moving on to the advanced approaches of the new capital framework.
� Banks have already started to disclose the risk profile of their portfolio according to the new methodology.
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RISK PROFILE OF CORPORATE LOANS ACCORDING TO THE NEW CLASSIFICATION SYSTEM
(FIGURES FOR JANUARY 2005)
5.5%
20.8%
4.9%
1.2% 0.5% 0.5% 0.5% 0.3%
37.8%
28.0%
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
A1 A2 A3 B C1 C2 C3 C4 D1 D2
Risk Category
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CONVERGENCE OF LOCAL ACCOUNTING RULES WITH INTERNATIONAL STANDARDS
� This is essential to enhance financial disclosure and market discipline.� Implementation started in 2004.� All deviations from international standards have already been identified.� An evaluation of the extent and significance of these deviations has been
carried out.� Regulations which, for prudential reasons, may need to be stricter than
international standards are also being identified.� The complete implementation of this project will take 2-3 years.
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SPECIFIC ACTIONS IN PREPARATION FOR BASEL II
� Quantitative impact studies.� Stress testing for capital adequacy.� Assessment of external credit ratings.
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ASSESSMENT OF THE QUANTITATIVE IMPACTOF THE NEW ACCORD
� The three largest Chilean banks took part in the QIS 3.� Subsequently, a similar exercise was carried out for the whole banking
system.� The evaluation was based on the guidelines of the standardized
approach.� The results show that Basel II would not have a major impact on
capital requirements.� In fact, using strict Basel criteria, the study shows a slight reduction in
those requirements.
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RESULTS OF THE QUANTITATIVE IMPACT STUDY FOR THE CHILEAN BANKING SYSTEM
Simulation Credit Risk Impact
Operational Risk Impact
Overall Impact
1. According to strict Basel II criteria -13.27% 10.33% -2.94%
2. According to stricter criteria (higher risk weights)
-4.77 10.33% 5.57%
3. According to even stricter criteria (same risk weights as simulation 2, excluding use of credit-risk mitigants).
-2.58% 10.33% 7.75%
Notes: a) The simulation used the standardized approach to credit risk and the alternative standardized
approach to operational risk.b) Figures show the percentage increase (decrease) in capital requirements.
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STRESS TESTING EXERCISE
! Stress tests were conducted to simulate the potential effects of significant macroeconomic shocks on the profitability and solvency of the banking system as a whole.
! The macroeconomic shocks considered were: a major currency devaluation or revaluation (25% from previous level); a drastic change in interest rates (200 basis points); and a significant deterioration in credit quality measured by a large increase in loan loss reserves.
! The results show that these macro shocks would have an impact onprofitability as measured by ROE, but only a limited impact on solvency as measured by the Basel I capital index.
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STRESS TEST FOR ROE AND CAPITAL ADEQUACY
Interest rate shock (1)
Exchange rate shock (2)
Portfolio impairment
(3)
Ex-ante ROE 14.4 14.4 14.4
Ex-post ROE 3.2 13.4 -8.1
Ex-ante Basel I index 14.0 14.0 14.0
Ex-post Basel I index 14.0 14.0 13.1
1) Interest rate change of 200 basis points.2) Devaluation or revaluation of 25%.3) Assumes that loan loss reserves double their level as of 1997-2002, the highest in 20 years.
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ASSESSMENT OF THE QUALITY AND PENETRATION OF EXTERNAL RATINGS
! The external ratings industry shows an intermediate level of development and appears to be prepared to support the implementation of the standardized approach to credit risk.
! External ratings are used extensively for regulatory purposes in the insurance and pension fund industries, and are starting to be used in the banking sector.
! The number of corporate and financial institutions with an external risk rating is growing, while 34% of the loan and investment portfolio of banks is subject to external ratings.
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THE ROAD MAP FOR THE TRANSITIONTO BASEL II
PRESENTED TO THE CHILEAN BANKING INDUSTRY
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GENERAL DECISIONS (1)
! The road map was presented in January 2005.! It provides general guidelines for the transition period.! Both Spanish and English versions can be found on our website:
www.sbif.cl! It is currently available for comments from the industry and market
analysts. ! This process is being led jointly by the Superintendency of Banks and
the Central Bank. ! Close communication and coordination with the industry will be
maintained. ! The transition will be gradual and stepwise.
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GENERAL DECISIONS (2)
! In the first stage, only the standardized approaches to credit and operational risks will be adopted.
! The transition to the standardized approaches is relatively simple and all banks will, therefore, be in a position to make it.
! In the second stage, the option of adopting advanced models will be offered.
! In this stage, large banks and the branches or subsidiaries of international banks will most probably move on to advanced internal models, while smaller banks maintain the standardized approaches.
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GENERAL DECISIONS (3)
! During the first stage, only the regulatory powers of the Superintendency of Banks and the Central Bank will be used.
! The legal reforms to consolidate the transition will be discussed and come into force at the end of the first stage.
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KEY DEFINITIONS ON PILLAR I
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APPROACHES AVAILABLE IN THE FIRST STAGE
! Credit risk: standardized approach.! Operational risk: alternative standardized approach (*). ! Market risk (two options):
! standardized methodology;! internal models approach.
(*) The standardized approach, which takes into account 8 lines of business, may also be considered.
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CREDIT-RISK WEIGHTS UNDER THE STANDARDIZED APPROACH
Claims on corporate firms 100% rating
Claims on banks 20%-100% rating
Type of loan Current risk weight
New proposed risk weight
Loans secured by residential property
60% 50%
Retail loans 100% 90% (*)
Claims on sovereigns 10%-100% rating
(*) This applies if the portfolio is adequately diversified.
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MINIMUM CAPITAL AND CAPITAL LIMIT APPLICABLE IN STAGE I
Concept Formula Rule status
Minimum Capital (MC)
MC ≥ 0.08 * RWA Legal rule
Regulatory ruleCapital Limit (CL)
CL ≥ 0.08 * RWA + MR + OR
Notes:(1) RWA = risk-weighted assets; MR = capital requirement for market risk; OR = capital requirement for operational risk.(2) Some banks are required to hold a minimum capital higher than 8% of RWA.
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TIMETABLE OF MAIN ACTIVITIES IN THE TRANSITION TO THE FIRST STAGE
! Quantitative impact exercises by banks.! Incorporation of market risk according to the standardized approach.
! Stress testing for capital adequacy by banks.! Option to move on to the internal models approach to market risk
! Application of capital limit incorporating credit, market and operational risks.
! Disclosure of information concerning risk management and capitaladequacy.
2005
2006
2007
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SUPERVISORY REVIEW
! The assessment of capital adequacy will be an important additional factor of our risk-based supervisory review.
! Risk and capital management will be formally considered in the process of assigning supervisory ratings.
! Banks will have to carry out stress testing for capital adequacy. ! Capital will be considered adequate if, under adverse conditions, it remains
over the required minimum.
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BRANCHES AND SUBSIDIARIES OF INTERNATIONAL BANKS
! From the start of the process, we will offer international banks and supervisors of their headquarters all the cooperation necessary to implement the new capital framework in their home countries.
! For this purpose, we have already established contact and relations with banks and headquarters� supervisors in a number of home countries.
! However, all banks operating in our jurisdiction, whether local or foreign, will be subject to the decisions and recommendations contained in the road map.
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DISCLOSURE OF INFORMATION
! Ownership structure, management, and scope of application.! Provisions for credit risks.! Credit, market and operational risks and their corresponding capital
requirements.! Capital structure.! Capital adequacy.
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AMENDMENT OF THE BANKING ACT
! A proposal for amendment will be drawn up during the first stage of the transition.
! Amendments will refer particularly to:! explicit charges for market and operational risks;! additional capital charges for banks under certain specific
circumstances (i.e. very small banks);! the use of advanced models in the second stage of Basel II.
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MAIN TASKS IN PREPARATION FOR THE SECOND STAGE
! Raising risk management standards in banks (achieving full command of advanced concepts and techniques).
! Preparing resources to move to advanced models in the next phase (collecting data, designing and calibrating models, etc.).
! Developing supervisory capacities in line with the requirements of advanced approaches.
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THANK YOU FOR YOUR ATTENTION